July 27, 2009
Biting A Bullet
John P. Hussman, Ph.D.All rights reserved and actively enforced.
In recent weeks, the dominant view of investors and analysts has shifted clearly to the expectation that the U.S. economyis in recovery. Appearing to seal the deal for some analysts was the third consecutive increase in the index of leadingeconomic indicators. For that index, interest rate spreads and the S&P 500 Index have been the strongest contributors inrecent months, as 10-year yields have shot higher from near 2% at the beginning of the year to about 4% beforeretreating a bit, and stocks have similarly rebounded from deeply oversold levels. Unfortunately, as I've noted before,there is little information content in mean reversion following extreme moves, and that's what the LEI is picking up here – to a much greater extent than has typically been the case at the end of recessions. Put another way, the case for aneconomic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in joblessclaims or other measures to a level that is on par with prior recoveries). The recovery argument also relies strongly on theidea that this is a run-of-the-mill post-war recession.That said, I can only describe our investment stance here as “uncomfortably defensive.” That is, the measures that haveguided the performance of the Strategic Growth Fund over time are still holding to a defensive stance, which is admittedlyuncomfortable with the market pressing strenuous but persistent overbought levels. It's a lot like watching people scaleacross a tenuously secured rope bridge and get a nice meal at the center. You'd like to climb across and join them, butyou know that too many things aren't right with the bridge, and it's not clear that the people who are eating will ultimatelysurvive.Our defensive stance here is driven by a combination of poor price-volume sponsorship, moderate overvaluation,strenuous overbought conditions, Treasury yield and commodity price pressures, as well as a variety of other factors thathave historically combined to produce a weak overall return-to-risk tradeoff. Moreover, from a fundamental standpoint, theebullience about an economic recovery is based on what I've frequently called the “ebb and flow” of short-term economicinformation that very well can turn hostile again – particularly given that there is no reason to assume that deleveragingpressures have seriously abated.As John Mauldin notes, “this is going to feel like a very different recovery from what we normally think of as recovery. Itwill be more of a statistical recovery than a real one.” Essentially, we've observed a great deal of contraction in somesectors of the economy, such as housing, inventories and business investment, but at this point sheer stagnation wouldmean that they would no longer subtract from GDP growth, allowing us to observe flat or positive GDP figures. As Johnasks, “Does that mean recovery? No, it just means that things aren't getting worse.”Still, knowing why we are defensive doesn't make holding a defensive stance in an advancing market any lessuncomfortable. We can certainly look back on the past several years and observe many instances where we felt the samesort of short-term discomfort, and where our caution was clearly validated later. It would be nice to be able to take risk in adangerous environment and get away with it. The fact is that you can get away with it, in hindsight, a good portion of thetime. But on average, you'd get destroyed. Suffice it to say we're biting a bullet.The extent of the recent rally is still smaller than the rally that stocks enjoyed following the 1929 crash (and was laterfollowed by spectacular losses). That doesn't mean the same outcome will follow in this event, but I continue to believethat the path to recovery will be far harder, with much greater headwinds, than investors seem to assume at present.Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking thepresumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning.In my view, investors have left themselves far too little room for error, not only in stocks, but also in corporate bonds. We'lltake our evidence as it comes, and change our positions as the expected return-to-risk profile of the market changes. Fornow, we remain defensive.
As of last week, the Market Climate for stocks was characterized by moderate overvaluation and mixed market action.Presently, we estimate that the S&P 500 is priced to deliver average annual returns of 7.3% over the next decade (theprobable range is 6% to 8.5%). Valuations are certainly not as poor as we saw at the 2000 or 2007 peaks (or during the“lost decade” between 1998 and 2008 where stocks returned nothing at all), but expected returns are clearly belowhistorical norms. Frankly, projected 10-year returns here are at levels that typically characterized market tops, not